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 5

NAPI<INS FOR PEACE:

DEFINING THE QUESTION

VERY AFTERNOON AT 3:30 the Hoover lostitution's senior fel-

10w5 get together in the Commons Room for coffee 01' tea and

some of the best coolcies 011 the \~lest Coast. In the summer of 1987, as
011 many other occasions, 1 took a break from my research lo enjoya cup
of coffee, a large chocolate chip coolde, and a bit of collegial camaraderie.
00 this particular July day, a distinguished Ismeli sociologist, Shmuel
Eisenstadt, \V35 visiting. He asked me what 1 was \Vorking 011, the stan-
dard conversation opener in the Commons Room, flnd 1 explained that I
was trying to improve my original forecnsting model \vhich was thcn sev-
eral years old. ./;.
Shmuel asked, "So, you can predict ho\\' to makep~~c-; in ih.e Middle
East?" This being a tall arder, I responded cautioosly that perhap\; 1 could
predict ",hat steps might be taken over the next feIV years to advance the
prospects of peace. I emphasized that this required data, not a crystal ball.
He asked ",hat data 1 needed and then, pen in hand, wrote on iny coffee-
stained naplcin and his napldn as IVell, Iisting stakeholders, their potential
infIucnce, salience, and positions on a scale measuring possible conces-
sions in the context of a multination peace conference. (The Soviet Union
IVas calling for such a conference in 1987.)
Eisel1stadt's question to me is pretty c10se in form to the questions I'm
asked to examine-whether by companies pursuing mergers, the Defense
Department trying to evaluate a terroríst thrcat, law I1r1115 trying to 50rt
 NaJ71úlIsfor Peacc: DCfillillg tlle QuestiOll 67

out suits, or tbe CIA trying to unelerstanel lran's nuclear ambitions-ancl

almost al\Vays, tbe c¡uestion asked is not actually tbe question for which
3n answer really is wanted or neeeled.

WHAT'S THE PROBLEM?

The big c¡uestion-how to malee peace in the Midelle East-is best an-
swered by working out \vhat the many smaller guestions are that, taken
logetber, acld up to a solution. Framing lhe problem is usually lhe harelest
part oF lhe prediction and engineering process, 1 nCver cease to be sur-
prised that even when billions of dollars or thousands of Iives are at stake,
decision makers rarely vvork through what it is they actualIy need to know.
They are usually astonisheel-fortunately, pleasantIy so-tb realize that
lhey have not lboughl systematically enough about their own problem to
kno,," ",bat it is lbey neeel lo know or clo.
For me, nnswering n question Hke "HO\v can v/e make pcace in the
Mielelle East?" involves breaking this c¡uestion clown to speci!ic issues,
to specillc cboices tbal must be made. Tberein Jies tbe Icey. Questions
need lO be about actual choices confronting clecision malzers ralher
than about abstraet iJeas Iike winning or getting ahead. IF yOLl want to
win, you necd to know ,vhat ít is that signifles you \von, yau lost, or you
e1id acceptably well, and by bolV mucho Only after \\'e have e1ra\\'n out ex-
actIy what subjects al' questions need precise decisions can we start
putting the analyses of all of the iSSlles together so that \Ve might suc-
cessfully identify the unelerlying stumbling blocks and find ",ays around
them.
For sorne problems, framing the problem is relatively easy. i'vIuch Iiti-
galion, for instance, revolves around a settlement priee. V,¡hat a clefenelant
reaJl)' wants lo know is "¡-lolI' much do 1 have to pal' lo resolve this law-
suit?" To answer that question, it's jllst necessary to know what demands
pbyers eurrently sal' they supporl, how salient lhe price is for eaeh stake-
holder, and ho\\' much c1011t eaeh eould bring to bear.
Of course, even lawsuits are sometimes more complicatcd than just
working out a settlement price. Discussíng a problem \vith a client. 1
might le3rn lhat they al so need to kno\\' ",hether all charges can be re-
 68 The Prcdíctionccr's Game

solved with one global settlement priee or whether the priee paiel for one
part of a lawsuit \ViII influence the priee that has to be paiel for anather
parto Once in a while, it gets still more complieated. There might be mul-
tiple defendants, so it's impartant to work out nat only ha\\' much has
to be paid to get the plaintiffs to settle, but ha\\' the cost will be elistrib-
uted aeross the defendants, their insurers, and other involved parties.
This sometimes lcads to questions abolll whethcr it makes sen se to drag
in other parties as co-defendants or not. Adding co-dcFendants ín\'olves
trade-offs. On the one hand, there will be more potential payers \Vith
more defendants. That can be a gooel thing, of course. On the other hand,
more defendants menns having to coordinate a strategy with many more
businesspeople, their lawyers, and theír insurers. That can gel confusing
and expensive. As you Can see, a simple guestion Iilce "What \ViII it take to
settle this lawsuit?" can guickly gro\¡' 'lnto a complieatee!, interlaeed set of
issues in which rcsolving one qucsUon changes hmv others can be re-
solved. That means IVe not only have to figure out ",hat the actual ques-
tions are that must be deeided, but al so the ,eguenee of agreements that
leads to the optimal outeome.
Business mergers me still more eomplex most of the time. Unlike Iitiga-
tian, mcrgers rarely hinge just 011 the price lo be paid for putting companies
together. Lots of other issues enler into a successFul rnerger. But mergers
can nlso be simpler than litigation in that th:: range of Jikely merger issues is
usual!y wel! defined [lnd tends to be pretty mueh the same across allmerg-
ers and acquisitions. The price to be paid (or to be o¡'taiJJedLis-'i1~,ways a
question, 01' course) but merger discussians rarel)' get nnywhere iE th,ere is
a substantial disagreement about the worth of a property. That mean~ that
the price rarely is the reasan un attempted merger or acquisition fails. Re-
member the example of a merger between a Freneh and a German ,bank in
an earlicr ehapter. That deal hinged on ",hether the German executives had
to move; they were willing to take a 100ver price for their bank ir they could
stay put in Heidelberg.
Several yems ago 1 worked ",ith an international team of analysts on a
majar dfort to crea te a unified defense industry aeross Europe, one that
eould compete with the American derense industry. \,Ve looked at virtually
every possible combination of deren,e firms in Britain, Franee, and Gcr-
many, as well as several possible combinations that "'QuId have included
 Naphil1s for Pe(Jce; Defil1illg the QllesUOIl 69

defense firms in Italy, Spain, or Sweden. The question put to us was "Can
Vl'e do these mergers?" To answer that que5tion, rny team needed to ex-
amine approximately seven different issues for eaeh possible eombination
of lirms for a total of more than seventy individual issues, eaeh represent-
ing a deeision that eou Id make or break a multibillion-dollar dea!. Same of
the make-or-break questions, the issues an \\'hieh agreement had ta be
reaehed, ineluded (1) the priee, (2) alloeation of management control be-
tween merged unit5, (3) the scope of businesses lo be inclucled or ex-
e\uded from the merged entity, (4) employment guarantees ror
\Yorkers in
various unil5 across national boundaries, (5) government's role in reguJat-
ing or sharing in ownership and managemcnt of the newly ereated firm,
(6) the timing of the transition to eombined lVorking units and teams with
shared technology, and (7) where the senior managers wauld be expeeted
to líve.
Merger efforts are more likely ta fail beeause of thc "Iesser" issucs than
beeause of a priee disagreerncnt. Yet few exeeutives seern to reeognize this
when they initiate the proeess. As a result, they spend millions of dallars
on getting good financial advice to SOft out the right priee to offer, on]y to
have many prospeetive deals fall through beeause too little effort has be en
investcd in working out othcr issues. Sometirnes these "other issues" can
seem so absurdly small that they are ignored, only to end up being, in
hindsight, the deal breakers.
A few years ago I worked on a failed merger in the pharmaeeutieal in-
dustr)'. The prospeetive deal IVas expeeted to produce great eflieieney
gains that eould have dramatieally benefited the pharmaeeutical market
anel preseription drug consumers. Almost al! of the executives in the t\Vo
firms involved were most enthusiastic about the opportunity, with ';almost
al!" being the key phmse. The killer issue that die! the deal in involved al-
locating management control bet",een the CEOs in the two firms. That,
af eourse, is no small question. The absurdity eame in hol\' the deal was
kil!ed.
The t\VO chief executives hated eaeh other, ancl, as i5 the case \vjth
rnany big companies in Europe, there were bitter family issues ]urldng in
the background as well. So deep \Vas the animosity between the t\Vo
CEOs that everyone agreed a way had to be found for them to work to-
gether before going forward. A dinner \vas arrangecl For the two oE them,
 70 Thc Prcdictioneer's G.1l11C

and senior aides, II'ho shoulel have smelled a rat, also allended. It took a
huge effort just to get this pair to sit at the same table.
The host CEO linally agreed to have the dinner at his home anel then,
without my or any of his own aides' realizing il, he planned a menu of course
after course of lhe other chid executive's most disliked fooels. Amazing as
it mal' seem, this prospeclive multibillion-dollar deal fell aparl nver a menu,
or, more accurately, over a deeply personal conflict lhat made all olher ef-
forts and points moot.
Working out what the right issucs are takes patience, gnod listening
skills, and the ability lo sleer a conversation toward what will really drive
results rather lhan the inchoate musings of the decision makers. Portu-
nately, lhe clinner menu rarely plays such a prominent part in negotiations.
Por me, Hn "issue" is any specilic 'Lueslion for which dilTerent individuals,
organized groups, or inFormal intetested parties have difFerent preferences
regarding the outcome, ancl For which it is true that an overall agreement
cannot be reached unless at Ieast a ke)' set of players come to agreement
on the question. It helps to knolV whether lhere is a slatus qua, and if there
is, lo make sure that lhe issue is Ilot constructcd lo be biased against lhe
existing situation.
Recently 1 taught a seminar in IVhich my students IVere askecl to piel: a
world crisis lhat interested them and to model a \Val' lo solve the problem.
One group DE students decided to examine cm'ban dioxide emissians (a topie
1 relurn to in lhe last ehapter). They clefincd un issue in which one end oF the
scale refleeled current CO, emÍssions anel the other~:~d _lhs,tifr~sl recluc-
tian advocated by any environmentaI group. Everything in bctwecn repre-
sented possible agreemenls among lhe players. Do you see the prohlem
herc? 1asked if they thought there were no cncrgy companies or others vvho
felt that CO, emissions should be less regulated than IVas the case at the
time, OE course there \Vere interested parties who wantcd lo have more free-
dom to produce CO,l So the \Val' lhe students had designed their issue was
biased. The 0111y answcr that couId come out of their exercise \Vas to in crease
regulatOly controls or, \\1th low odds, keep them the same. Their seale al-
lowed no possibilily of anyone wanting to produce 11I0re earhan dioxide.
111e)' had umvittingly created a biased issue, one lhat made lhom feeI good
but would almost certainly Jcad to n \VTong answer. Such fundamental Aaws
in the design DE questions ensure that the answers to thcm wiIl be useless.
 NlIpldnsfor Peace: DeJillil1g tIte QlIestiDlI 7¡

YOU CAN'T ALWAYS GETWHATYOU WANT,

BUT IF YOU TRY ...

Once an issue is properly frameJ. \Ve have to think about how to capture
the thaught process that people go through in working out decisions.
\i\fithout doing- that, without c1imbing ¡nto the heads of .vaur rivals, vou're
-
nat likely lo get what you want. You're not even likely to know ho\\' lo tr)'
lo get what you need.
The game slructure 1 use loaks al choice s as sometímes involving co-
operation, sometimcs competitíon, and sometimes coercion. The most
cOll1plicated parl is to try to emulate ha\\' people lhink aboul changes in
lheir situalion as \Vell as ",hal olhers sal' aod do. Players are al",ays intcr-
esled' in allering lhe lay DI' ¡he land in lheir Favor. They wanl to surrounJ
thcir desircd outeame with tall mountains of power that are flard lo over-
come. They want to tear clown mountains oF oppositioll, levcling the
power tcrrain Jround posítions the)' \vant to defeat. At every step along
the \Val', everybody has lo \Vork out ",ho \ViII help them anel \Vho \ViII get
in the way. 'T'hey hove to calculate the risks and rewards, costs and bcne-
fits of actively trying to change other people's choices or lying 10\\', trying
to sla)' out 01' the line of nre_ The math can get complieated, I but let's look
at sorne example, of the process at work that \Ve should be able to follow
prettyeasily.
The table belo\V shows the small data sel that resultee! from tbe coolde-
and-coffec conversation [ had ",ith Shmuel Eisenstae!l in 1987, aug-
mented in 1989 by a discussion \Vith [-Iarold Saunders, ""ho by thcn was
the former deputy assistant secretar)' of state for the Near East anel North
Arrien. The conlinuum of possible outcomes on the settlement issue
rangeJ [rom the establishment 01' a fully independent, secular Palestinian
slate at one extreme to the annexation by Israel of the \Vest Bank and
Gaza at lhe other extreme. Position 30 on the scale was defined to repre-
scnt territorial coneessions granted by Israel to the Palestinians without
establishing an autonomous state but establishing instead a Palestinian
political entity [ederatee! ,,·ilh Jordan. The 1987 status quo was localed at
lhe position equivalent to 85 on tbis seale (under the "Negotiated Settle-
ment Oplions" column). There \Vas no semí~autonomous Paleslinian ler-
ritory ar government at lhat time.
 72 The Predictionecr's Garne

Player 11lj111eHce Negotiatecl Settlemellt OptiOl1S Saliellce

JsraeJi Settlers 100 100: [srael annexes West Bank 99

and Gaza

SHA 85 85: 1987 Status Quo 85

.---~~-~-~ .. ~ .-~ -~. --._-~~ .._--,,-

Hard-Jine 85 85: 1987 Status Quo 90

60 70: Palcstinian territory \\ith 50

weakest autonomy

Israelí Defensc 100 60: Semi~autonomous 80

Forces territory

Labor Party 60 30: Close federation with jordan 75

OCC 100 25: Close federation \Vith Jordan 95

PEA 70 20: Loose recleration with jordan 85

PLO 100 20: Loase federatían with Jordan 95

PFLP 20 O: Independent, secular 95

Palestlnian stLlte
----~-".""~-_.,,

FNO JO O: Independent, secular 80

Palestinian state

It is not hard to see how territorial concessions can be orgariized on a

continuum. Although the scale above is not baseel on percentages of lanel
or land valuc, still there is a natural progression in choices ranging from
Israel's annexing contested territory on to no concessions by 'the Israelis
anel finishing at the other encl of the scale \Vith a [ully independent Pales-
tinian state. From these beginnings in 1987. [ prepared a forecast that
would clos.ely predict the actual territorial concessions agreed to between
the [sraelis anel the Palestinians in 1993 at Oslo. (We \Viii look more
c10sely at this foreeast a Iittle later in this charter.) Let me reemphasize a
central assllmption behind the scale, an assumption [ introeluced casllally
in the discussion of North Korea. The scale tells us that someone aelvo-
cating a weakly autonomous Palestinian territory (70 on the scale)
 NllphíllS far Pence: Def¡,liug t 11e Questioll 73

strongly prerers the status quo (at 85 on the seale) to a territory closely in
federation ",ith Jordan (25 on the seale), We know the preferenee for 85
is stronger thnn for 25, even though 85 and 25 flank the advocated pasi-
tion at 70, beeause 70 is much closer numerical!y to 85 than to 25, That
ís haw each scale works. Numerical values that are closer to the numeri-
cal value of the player's advocatecl position are liked better by the player
than positions reRected by numerical values farther from the advoeated
position. Knowing that, let's have a look at a business issue that can help
us understuncl more about how to tum problems into a ",el!-delinee! nu-
merical scale.

!(J EJ ¡~

Here the foeus is on what an issue's seale might look like when the ques-
tion invo!ves something les s obviollsly numerical in character than land
For peace. 10 see an answer to this, consicler the following range of
choices fram a litigation 1 worked on sorne time ago. Natural1y 1 have
maskecl the details to proteet my elient, but the ideas shoule! be clear
cnollgh.

WI-IAT el-IARCES WILL THE U,S, ATTORNEY

BnINC ACAINST THE DEFENDANT?

Sea le Position iHell11illg of the NUHlcrieal \illuc OH- the Scale

100 MuItiple felony charges inclllding several specific, severe

Felollies
90 Several specif-ic, severe fclony cOllnts but no les ser felonies
80 One cOllnt of the scvere feJony plus scycrallesser felonies
75 Onc count of the severc felony but no other felonies
60 Multiple felony counts but non e of the severe felonies
40 1\:'Iultiple misdemeanor counts plus OIle lesser fclony
25 rVJultiple misdcmeanor cOllnts and no Felonies
O One rnisdemcallnr count

This seale makes elear ho\\' the elient prioritized passible outeames,
The c1efinition of O an the seale tells us that the elient did nat believe that
any stakeholcler would argue for the dismissal 01' al! charges, That was nat
a choice inclucled in the range of [easible outeomes, The upper bound on
74 The Prcdictioneer's Game

the seale indieates that the elient believed at least sorne in the U.S. At-
tomey's Offlce or olhers involved in the praeess would argue for severe
criminal penalties, The real aetion was to unfold in between, and we'lI
take a deeper look at this "case" in a later chapter.
Let's take a quiek look al this issue seale. lt can sheJ a lot of light on
how to think about issues. We can see that the two key "distan ce" differ-
enees here, laid out by the elient, are the plea fram 25 to 40 (no felon)' vs.
one lesser) and fram 40 to 75 (no severe vs, one severe), After that, life
gets warse. but nat nearly as dramatically worse as happens with the move
fram 40 to 75. This telIs us, among other things, that avoiding asevere
felony eharge altogelher was of grealer value to the elient than adjust-
menls in the number of severe felonies thal might have to be pleaded lo,
In framing issues this carefulIy, the deeision makers begin te lea m
things they had nol reeognized 'about their o\\'n problem. lnstead oE an
amorphous question, they now have foeused issues to address. They have
eonfronted the prablem and defined ",hat the meaning is behind the
choice s they faee, Once they go lhrough the intervie\\' proeess to identify
lhe rcmainder oE the data-who the players are, ",here they currentIy
stand on the issue, how salient it is lo them, and how much eloul they can
eaeh exert-they have, for the fírst time, a genuinol)' comprehensive view
of how high a mountain they must elimb, As I mentioned, IVe wil! revisil
this case in a latcr chapter to see how they thought it would turn out and
how it actualIy did turn out. For no\\', let's retum to the napkins eovered
with data on how to promote peaee in the Middle East. --- _ ~"'\:':
""";"--.-

PEACE IN THE MIDDLE EAST?

The information seribbled on a eouple of napkins tumed out lo provide a

terrifíe grounding for figuring out what was going to happen in the Middle
East over the several years following 1987, Eisenstadt lenew his stuff, and
so did Harold Saunders. \;Vhat did \Ve leam when the data \Vere subjeeted
to the mode!'s dynamies, alIowing alI of the players the opportunity to bar-
gain with eaeh other, trading territorial eoneessions for political credit?
The predicted outeome \Vas reported in a 1990 joumal article I wrote
based on the eookie-hour napkins. ' The artiele was published three years
 Naphius for Pcace: Dcfinillg tIte Qlles/,ion 75

before lhe Oslo Accords crealed the Paleslinian Authorily. It predicled

resolution at position 60 on the issue scale out of a feasible range of O to
100. Sixty on the scale \Vas denned at the time as being equivalent to the
Palestinians' gaining sorne lVeak localized territorial control over a semi-
autanomous entity. Hemember, the status quo \Vas 85, and IOlVer values
reflected greater and greater concessÍons to the Palestinians. We now
know that the territorial concessions that were actually \Vorked out be-
tween the Ismeli government and Yasser Arafat \Vere equivalent to aboLIt
60 on the scale, as [ predicted in print three years beforehand.
Of course, this prediction was made a long time ago and \vas in tended to
be good only once there \Vas a change in Israel's government. As 1 wrote at
the time, "Given [then lsrae!'s prime minister Yitzhak] Shamir's apparent
perception oE lhe situation, we must conclude that as long as he is Prime
IVlinister of Israel, there is no reason to expect signiflcant progre'ss." Shamir,
""ho became [srae!'s prime minister in October 1986, \Vas replaced by Shi-
man Peres in July 1992, pa\1ng the ",ay for real progress bet\Veen the [s-
melis and the Palestinians.
The analysis, ho\Vever, IVas more detailed and nuanced than just a pre-
diction of territorial conccssions. NIy 1990 study \vent on to suggest Lhat
the then large and influential Popular Front fOf the Liberatian of Palestine
(PFLP) wauld "become politically isolated and irrelevant in negatiations.
'vVe can anticipate that they would respand to such a situation by increas-
ing terrorist acts, aimed not 0(1)' at the [smelis but perhaps also at the
PLO leadership. If the amlysis is correet and if the PLO adopted a strat-
egy of incremental moderation, the future of the PFLP would be to flicker
out af the picture." Remember, this was out there for anyone to see and
read in 1990. That is ",hat [ meant earlier when [ said we must be \Villing
to risk embarmssment if we \vant people to have confidence in our pre-
dictions. Certainly few in 1990 would have argued that the PFLP \Vas
likely to "flicker out of the picture."
Toda)', t\Va decades later, \Ve can look bacle to see ha", accurate that
prcdiction \Vas. For instance, what do independent sources now 5ay aboLIt
",hat happened to the PFLP following the creation of the Palestinian lIu-
thority in 1993? BBC Ne",s Online, reporting on January 16, 2002,
quotes libele! Bari Atwan, editor in chief of the London-based Arab news-
paper AI-Ol/els, as saying "The movement [i.e., the Popular Front For the
76 The Predictionecr's Gnmc

Liberation 01' Palestine] had beco me marginalizeel .... Il hael gone fi'om
being the seconel most important Palestinian group lo forth [sic] or firlh.'"
Anthony Corelesman, a highly rcgareled Midclle Easl scholar anel expert
commenlator I'or ABC News, eehoes the BBC vie\\'. Reflecting bacle on
the PFLP, he writes, "The PFLP opposeel the Oslo peace process. As the
PA [Paleslinian Authorily] anel Ararat's lOatah gained strenglh, the PlOLP
became increasingly marginalized,"-l Similarly, GlobaISecurity.org, gencr-
aUy secn as a ~cliable sourcc oF inFormation, notes that, "Once a key pbyer
in Palestinian pnlitics, the PlOLP lost inRuence in the 1990s and \Vas si e1e-
Iined as Yasir Arafat establishecl the Paleslinian Authority." The PFLP's
decline is similarJ)' reporled by numeraus nlher sources. Mast al' these
sources attribute the PFLP's decline to events lhat happened aFter my
1990 mtiele IVas published anel long al' ter Shmuel Eisensladt wrate num-
bers 011 a couple oF napkins. That 'Is, the modeling exercíse undertaken
beFore the 1991 Gulf War, before the first intifada, ancI beFore the Oslo
Aceords foresa\\' the terrilorial changes between the Israelis anel Pales-
tinians, the necessity oF él Labor government coming to power in Israel,
and the decline of the PFLP. It foresa\\' the fundamental devcIopments
far enough ahoad that even todal' people have trouble recognizing lhat the
seeels of the agreement in 1993 hael aIread)' be en planted and \Vere gro\\'-
ing, Ullseen by most onlookers, wen befare.
What \Vas it thallhe model identified in the give-and-take between the
Palestinian side and the Israelí side based on data collected in 1987 anel
1989 that led to a sueeessful prediction? This is real!)' th~c¡:uxor.the mat-
ter. Afte¡- all, wor!dng out that the predicted outcom~ could le"dto a sta-
ble agreement involved more than just pondcring Eisenstadt's original,
vague question: "So, )'ou can precIict ha\\' to make pea ce in tbe lvIiddle
East?" Sinee Arafat ancl lhe Israeli prime minister both bad vetoes over
any cieal, it was essential to figure out whether they were likely to end up
supporting the same agreement, and if so, why. I-Iere's ",hat the model in-
dieated:
Israel's Labor Party leader, Shimon Peres, was not in powcr when thc
study \\'as done, and it \Nas evident in lhe mode]'s results that until Labor
carne to power no agreement could be reached. That meant that the Focus
of attenlion in analyzing lhe possibility of a peace cIeal-lhe problcm put
lo me by Shmuel Eisenstadt-had to be on Peres anel the Labor Party.
 Nllphills Jo!" Peace: DeJiniug die Qucstioll 77

The mode!'s logie produeed oUlpul that indiealed lbat Peres believed he
IVould faee a lol of polilieal pressure al borne over his slanee regarding lhe
Paleslinians. To attain and retain pOIVer-tbe goal of every politician-
he believed (aeeording to lhe mode!'s logie) that he had lo look as though
he ",ould be tougher in Palestinian negolialions than IVas implied by the
quile moderate stanee he look in the la le 19805. The model sholVed he
needed lo be only a bit more moderate than Shamir, leading him lo agree
lo oeeupy a position in lhe mid- to upper 60s inslead of Shamir's drifl be-
t",een 70 and 85 on the seale. So Peres was predieled to be responsive to
politieal expedieney at home.
For his parl, Arafat eoncluded, aceording lo the mode!'s simulations,
that he needed to moderate his o\\'n stanee to keep Labor from taking too
hard-nosed a view within Israel. The model suggcsted that he would
ehoose a eourse of aetion based on his personal politieal w'elfare ralher
than the well-being of the Palestinian people per se. As 1 wrote in lhe
1990 article, "The model solution suggests that Arafat would stabilize his
politieal posilion, leaving himself devoid of serious politieal opposition ei-
ther among the Palestinians or within Israel. ... If Arafat does ehoose to
moderate his stanee, lhis suggesls that he is willing to saerinee both lhe
Palestinian cause and his opponents at the al lar o[ his personal politieal
\Velfare." That seems to have been the case. Thus lhe analysis went from
a vague question to precisely structured propositions and a detailed analy-
sis of the negotiating dynamics that made it impossible for Shamir nnd
Arafat to reaeh agreement anel those that made it possible for Afafat and
Peres to come to terms once Peres became prime miníster.
Asking the right questions and isointing the key interests for a given
problem is too often a step that's not taken fram the beginning. Instead,
we settle for conventional wisdom about the reasons behind aetions that
seem lo fit the puzzle. Tile eosts of lhis laziness can be grave, partieularly
\Vhen the problems are the Idnd for whieh soeiely seeks remedies in arder
to prevent their recurrencc. \~lith an ¡nitíal misdiagnosis the \vrong treat-
1

ment will most assuredly follOlI'. Had poliey makers paid attention sooner
to the pulls and tugs Iikely to faee Arafat as IVell as the ¡smelis subsequent
to Oslo, perhaps they eould have managecl eireumstanees better and
might have avoided many of the setbacks between the Israelis and Pales-
tinians sinee 1993.
 78 Thc Predictioneer's Carne

DON'T ]UST LOOK WHERE TI-IE LAIVIPPOST SHINES

The failure to zoom in 011 what the issues are, ",ho the players are, what
their incentives are, and how lo f-LX those incentives is Ilollimited to prob-
lems in foreign "ffairs. The business IVorld sufrers at leasl as mueh from
lhe same diffieulties. 1'0 lake an example of lhis From recent years, let's
look at a model thal col!eagues and 1 developed lo identi/'y the causes of
and solulions lo eorporale Fmud.
Since the Enron debacle, Congress has made él real clforL to strcngthen
corporate incentives lo rerort honestly by introducing a massive <lmount
ofnew regulation through the Sarbanes-Oxley bil!, passeJ in 2002. How-
ever, I'!TI afraid Sarbanes-Oxley touches 011 but ciDes nat nail the rout
causes of fraud, al least not as thosg causes are secll by the model my col-
leagues anrl 1 developed. As \Ve cal, see in figure 5.l. fraud liligalion is
once agaín 011 the risc, despite lhe passage oE Sarbanes-O:dey. Sincc the
rccession began in 200í. fraud has skyrocketed aheacl (lf its pre-clownturn

FIG. 5.1. Federal Securities Class Action Litigation. 2002-2008

300 T, - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ,

250

~ 200
;;:
~

~o 150

•
~
E
o
z 100

50

o
2002 2003 2004 :::005 2006 2007 2008
Yeilrs Under Sarbanes-Oxley Regulalions

Source: Stanford Law School Class Action Clearing House, http://securities.stanford.edu/

 Naf1hilzs for Peace: Defillilzg 11ze Qucstirm 79

2006 level. This is just a bit al' evidence-there is more to come-for

my model-based belief that the premises that guided Congress in passing
Sarbanes-Oxley \Vere misguided, President Obama promises a ne\v wave
o[ regulalory controls to rein in the risk al' business [Taud and [ailure. Let's
hore that his administratinn and the Congress are more attentive to in-
centives so that they get the regulations right.
Ta regulate the rislc al' fraud il is fundamental thal \Ve flrSt underslalld
the motives for cOITImitting fraud. Ha", does the model that my colleagues
and 1 worked on determine which companies have an incentive to commit
fmud and ",hieh do llot?
Our game-theory approach is a variant on the study \Ve clid to under-
stand how nations are governed (recall c1ear old Leopold). But pay atten-
tion, as the context of the corpomte setting provides a most interesting
twisl. As we sa", in our study of Leopold and other heads of ,tate, loyalty
to leac1ers is much vveaker in democracies beca use the competition 1S Qver
policy ideas cather than the personal enrichment of a few supporters.
Much the same might be said [or corporations and the survival of corpo-
rate cxecutives, From this starting point, we might nssume that the out-
come in the business world would be the same as that in the political:
"autocratic" leadership Ieads to corruplion (fraud), while more "demo-
cratic" leadership cIoes not. This is llot tllC case. Perversely, as \Ve \vill see,
the strong loyalty engenc1ereu by relatively autocratic corporate styles
helps redilee the risk of fraud. 10 ullderstand ",hy, we have to leave the
light al' the Iumppost ane! really loole behind lhe seenes al the logie that
governs corporate behavior.
Big lirms have millions of shareholders. Yet few of them altend the an-
nual shareholders meeting, and they have little idea af ho", the business
is run or ho\\' it might have done if it had be en run c1ifferently. They duti-
fully sead in their proxy, vating the IVay the board suggests, or they tos s
their proxy statement in the recycling bin and do nat vote at all. Big blocs
01' votes are controlled by él small number of institutíonal investors, senior
executives, and directors. They, not the shareholders, decide ho\\' to run
the company. The more institutional investors and powcrful shareholders
therc are, the more parties to whom Lhe managemenl is accountablc. Ring
a bem It's the challenge presented to any leader: the more "democratic"
the system (think of demoerac)' not as an absolute concept bul rather as
a eonlinuum), the more people to picase.
80 The Predictioncer's Carne

When things are going well, the incentives fOI lhe executives running a
company are not incompatible \Vith the shareholders' interests. Growth in
prollts is good fOf the executives and it is good fOI the shareholders. Hut
sometimes thíngs do not go \Vell. Then the interests 01' management and
shareholders might part \Vays. Let's see ",hy.
In clcveloped eguity markets, the fraud model indicates that account-
ing fraud typically results because management is trying to preserve
shareholder valuc. Don't get me wrong. The Fraud moJel cIoes not thínk of
executives as altruists \Vho lose sleep trying to think up \vays to l1lnke
shareholders better oFf. They commit fmud to protect their job s in the
face 01' poor performance rather than as a result 01' a dcsire to defraucl in-
vcstors per se. That means \ve can use public records lo link the 1ikcli H

hood of [mud to any publicly trad"d corporation's reported performance,

ownership oversight, anJ governaÍ'lce-induced incentives to manage the
firm truthfu lIy.
Exmnining publiciy available infom1ation taken from SEC filings, my
colleagues and I faund that the amount paid in di,ielencls ro sharehalders
and salaries to senior management during yems 01' honcst reporting and dur-
ing years immediately preceding fraucluJent reporting difFer in signincant
\vays. In the fraud years, senior management reccive less compensation-
you rcad that right, less compensatían, Dot more-than expected gi\'en their
corporate governance structurc and reported corporate perFormance. Di\'1-
clencls rypieally also fall short of expectatians. AII lhe ",hile, reported per-
formance and ¡hererore the firm's growth in market capJlaliz¡¡tion look
,'_.- -,.- '\'"
healthy, just as they do in honestl'ears. It is important to note thatrhe com-
pensation for senior management may stil! llave increased in such fraud
years, and in an absolute sen se may still be guite granel, but the critical
point 1S that if things are rcally going 50 s\vimmingly ror the company, then
compensation should be even higher than it is.
The logie behind the model we designed pinpointeel these as trends to
loo k foro We didn't know whether we would actually Hnd tbese patterns in
SEC Hlings but we did kno\V that they \Vere the key to predicting haud if
c
our model \Vas right.
\,\,Ihy these patterns? CEOs al\Vays have incentives lo take aetions that
protect their jobs. If they see that their company is not performing up to
market expectatioll, theyare at risk and will take action to salvage their sit-
uation. No\\', they can argue thal the firm is the ,"etim of unforeseeable
 NlIphimJor Peace: DeJiuiug t.lte Questiol1 81

shoeks for whieh they should nat be hele! aeeountable (this was the argu-
ment made b), the CEOs 01' CM anel Chrvsler, in seekin oa a aovernment
o
bailout-they pointeu lo the cconomic downturn, not managcment's cleci-
sions, as the cause oE the auto industry's woes), but such argumenls are
risky to sal' the least, ane! mal' not be adequate to proteet a CEO's jobo
If blaming the economy or sorne outside force doesn't salvage senior
ITInnagcment's siluation, thcn the top executives might misrcpresent the
eorpofilrion's true performance. If they can sel! the belief thar the eom-
pany is performing just fine, then lhey \Van 't be at risk oF being fired. It is
difficult ror outsiders to knov'i' the corporation's true volume of sales, rev-
enue, COSt5, aod prolits. iVIarket eapitalization relleets rhese faetors, ane!
indeed these are the factors thar when Falsely reported and subseguently
detected result in accusations of accounting Fraud.
lf revenues are exaggerated or cosLs are understated, Lhen senior excc-
utives can temporari1y lcad thc marketplace {,o misjudge the true \vorth of
a campany, rnakíng the campan)' appear (Ealscly) to ha\'e met or exceeded
expectatians. This, the model suggests, is the esscntial rnotivation behincl
eorporate fraud.
This wodge belwocn 10wer-than-e'l'eeled stock dividends ane! 0001-

pensation rOf executívcs and seemillgly n01"11181 ar good growth in l11arket

capitalization is thereFore 8n early-warning inclicator of an elevated risk al'
fraucl. Neilher the SEC nor many cOll'0ratians, hawcver, secm to realize
thc impartance of this informatían in cletecting cady signs oE trouble. Sar-
banes-Oxley certainly does nat dra\\' attcntion to analyzing the size of tbis
beneflts \vedge.
The game's logie amI lhe evidenee cullcd [rom more than a decade of
corporate filings across hundreus oF ftrms 3150 raise questions abaut jour-
nalistic aeeounts and popular pereeprions. ¡\ prelty standard journalistie
vicw oF fraud is that grecd)' cxecutives aeL lo enrich themselves aL the ex-
pense of shareholders anel cmployees, lhat they are little more than loot-
ers, and lhat the problem boils clown lo ootrageous charaeter fIaws. This
kind of thinking gets us nowhere.
Too often \Ve looL al what happened most reeently aocl assume that
earlier actions were lllotivated by those ends. It is easy to believe that
PTeedv_ executives cook Lhe boaks to enrich themselves, \vith selF-interest
n

ticd merel)' to short-term gain (01' course 1 would never arguc that self-
interest isn't the kcy motivatian, bul \VC I1111St examine cxactly vvhat the
82 Thc Predictioncer's Gamc

nature of that self-ínterest is). But in doing so we Forget, ¡'-or example, that
Enron's fraue! startee! amune! 1997 ane! yet the senior managers die! not
seIl off their shares until amune! 2000 ane! 2001. Why \Voule! they have
waited so long, risking diseovery for years, berore cashing out? True, stock
prices were going up, but equnlly true, lhe risIc of being uncovered grew
greater ane! greater with each passing month ane! year. Did they reaIly only
seek the gains to be made in the period from 1997 lo 2001, or were they
hoping for mueh greater gains five, ten, or f-ifteen years on?
We won't analyze the problem properly if \Ve look for the causes of
Eraud in its end result. Remember, corrdation is not causation-the be-
ginning, not the end, is where the explanatian lies.
In the Enron case, it seems clear that by 2000 or 2001 the most senior
leadership in the company realiz~e! that they could not fix its problems.
Having reachee! tbe ene! of tbe cotporate game, they cashed out. It is de-
spicable that they did 50 ",hile covering up the true state of aEfairs,
thereby leaving their pensioners on the hoolz. But it secms eguaIly evident
that Enron's senior management did not hang on for Four years befare
cashing out just to enrich themselves and walk a\Vay. All that time, ac-
cording lo the game's logic, they were trying lo savc the campan)' becausc
their longer-term interests woulcl be rewarded if they were successfuJ in
doing so. lf the numbers had to be fudged ",hile they correctee! the com-
pany's course, so be it. In their view, the end justified the means. None oE
that \Vas going to happen if the shareholdcrs, and especially il" key board
members) found out what trouble Enran was in. ___ ,_o?;
~:,' -,-- - \>;
Give executives the wrong incentives and you éan count on,their tak-
ing actions \-vith bad social consequences. Give them the right incentives
ane! they \ViII do what is right, not becmlse they are fillcd \Vith civic virtue
but because it \ViII sen'e their own interests. Remember Leopold? He had
pretty good incentives in Belgium and he did good things there. He hae!
horrible incentives in the Congo and he did horrible things there.
\~lhat, then, are the right and wrong incentives? \Vhy do sorne compa-
nies cornmit fraud while others-the vast majority of firms-even in dire
circum5tances do nat? In answering these questions \Ve can gajn insight
into how to alter incentives appropriately and how to anticipate ",ha has
the wrong incentives and i5 at serious ri51.:. of cornmitting fraud.
One elear implication of the fraud model rny colleagues and I devel-
opee! is that the bronder the grollp of people CEOs rely on to keep their
 Nllpldlls for Pel1ee: Defillillg dw Questirm 83

jobs, the more Iikely it is that the shareholders who put them in power \Viii
thro", them out. That's what happens to leaders of democracies, and lhat
is what is more likely to befall underperforming CEOs in relatively demo-
eratie eompanies. To save themselves¡ they are perversely ineentivized to
misrepresent the corporation's tme performance so that they don't have to
explain unclerperformance in the [irsl place.
This is not to sal' tbat more "autoeratic" companies (fe",er people to
pIcase in tbe p'o",er stmcture) are incapable of fraud. It's just that things
have to be considerably worse For those companics befare management
sees sufficient risk lo their jobs that they are tempted to engage in [raucl.
Our slicling scale extends across the public/private company divide as \Ve
consider partnerships (think of them as oligarchies) and family companies
(monarchies).
Government regulators anel boards of directors could do a better job al'
protecting shareholders anel employees from the risk 01' fraud. To do so,
the foeus needs to be more sqllarely placed on the incentives execlltives
have to monitor themselves and their colleagues in the face of declining
business perFormance. Knowing hoy\' to adjust governance structures to
induce the rigbt incentives is Lhe wal' to regulate nrms successfully. Bal-
nncing incentives in good times ancl bad is a major challenge for running
II business in a way that attracts and retains top-quality executives and

satisnes shareholder e.\.']Jectations. Optimal corporate governance design

needs to be done on a case-by-case basis, taking the natme af the firm's
market into account. A sweeping regulation cannot facilitate the fine-
tuning that is needcd lo get incentives right. Cnnf-idence in business re-
quires that \Ve move in these directions rather than putting our energies
into finding greedy individuals lo blame or one-size-fits-all fixes for what
are manifestly corpOl'ate governance problems, Looking for greed is just
like the drunkarcllooking for his keys under a lamppost. More often than
not, what's lost is not under the hright lights,
In a broader sen se, if \Ve truly want to make it easier for corparate ex-
ecutives to come clean abaut problems the)' d¡scover as soon as the)' dis-
eaver them, then \Ve al so aught to change the law so that they are nat
pUIlishecl for spilling the beaIls on themselves.
LOls aF companíes cliscaver problems \vith their prodllcts ar their per-
formance long befare these problems become public. ¡ndeed, it is a gaod
bet that some serious problel11s never become public al all. A few years
 84 The Prcdictiollcer's Carne

ago, for instance, the 3M Corporation pulled Scotchgard off the market.
Scotchgard was onc of its biggcst earners, and yet one day it Was in the
stores ancl the next it was gone. A Fe\-" years later, 3IVI introduced what it
called a ne"" improved Seotehgard. The EPA and ather firms in the ehcm-
ieal industry wondered ",hethcr 3M had discavered a hcalth or safety risk
associaLecl with the main chemical in Scotchgard, a chemical nat Found in
its "nc\'V and improved" product.
1 dOIÚ kno\\! whether 3Ivl cliscoverecl a problem or jusI Jecided one (by
to change a successful producto Imagine that they did fmd a problem.
What would they-no, better yet, ",hat erJltld they responsibly do? Cam-
pany leaders in such situations may be eager lo reveal whatcvcr it is Lhey'\'c
discovered, but Lhey aIso realize that doing so would \'iolate their f1duciary
duty. They are damned if they do a!,d damned if they clon't. A publie an-
nouncement ¡caves them opcn Lo b\,isuits by people \Vho llscd Lhe product
beFare anyone-insidc or outsiJe the company-kne\\' there \vas u prob-
¡em. These suits can be devastating to shareholder \'alue, and it is share-
holder value that corporate directors are legal!y obliged lo protect.
Probably many companies would reveal what they know when they dis-
cover trouble ir the government would immunize them against prosecu-
tion for nny problems in their products that \Vere previously unlmown to
them. The go\'ernment \NOn't. Litigation i5 the favorec1 solutian, as op-
poseel to rewarding responsible, public-spirited actions by corporate exec-
utives in difficult straits. The result is that corporale leadcrs are given the
wrong incentives. Remember all the litigutÍol1 surrounding..lhe~problems
~... -". \~

caused by DDT? Do you al so remember that the Hayal Caroline Institute

won the Nobel Prize for Physiology or Medicine in 1948 for developing
DDT? With litigatian run rampant, we fail to provide corporations and
their leaders with protection for reasonable expectatians and
decisions that, not by any misdeeds on their parts, mal' simply turn out to
be wrong.
In this chapter, we've explored haw to frame questions, The milin idea
is to isolate the individual components 01" a problem rhat shape its resolu-
tion, Then jt's a straightForwarc1 matter of turning those isolated individual
components into issues that, depending on the CÍrcumstances, ma)' be de-
cided separately or that may be Iinked to each other. Once an issue is \\'ell
defined, expert, have an easier time talking about ",ha rcally \ViII try to in-
fluence the decision on eaeh item. Then \Ve can have the computer play
 Naphills Jor Peq.ce: DeJillillg the QlIcs/ioll 85

the foreeasting Hnd engineering game to símulate \vhat proposal5 ea eh

player is cxpecled lo make lo cach othcr player 00 a rouod-by-rollnd basis,
and \Ve can bring into relief the incentives that players have to accepl or
reject proposed solutions.
'vVith the computer program at the ready, we can sort throllgh the prob-
lem and oot only predict results, as 1 did ",ith the napbos, but begin to
cngioeer results to change outcomes, as 1 hinted could be done to prevcot
eorporate fraud. Engineering outeomes 15 the subjeet oE the next two
chapters.